The S&P 500 declined 1.6% on volume below Friday and much lighter than the 30-day moving average volume. The decline on Monday was sufficient to trigger the stop-loss algorithm contained within our automated market forecasting process, so we are not forecasting an uncertain trend from our technical analysis. If the S&P 500 advances about 4 points (+0.4%) on Tuesday the trigger could be reversed and our automated forecast could return to a growth trend.

Subjective Comment:

We have been very skeptical of our automatic forecast lately because of the collapse in the US M2 money supply growth rate. The susceptibility of our stop-loss algorithm during periods of high market volatility and sideways (flat) market trends is another concern we have warned about, along with the daily patterns of strong-volume down-days combined with light-volume up-days. This being said, Friday and Monday were both an interesting change in the weakness of the daily market patterns. Last Friday was a strong-volume up-day, and Monday was a light-volume down-day. This makes two consecutive trading sessions where the pattern is more akin to strength. The M2 money supply data published by the Federal Reserve is two weeks delayed and with nearly $1.5 Trillion in excess reserves US banks could resume rapid lending at any moment. If US banks have resumed lending aggressively, some of the funds from those loans will eventually wind up in the stock markets and move prices higher. The daily S&P 500 patterns need to be watched closely to see if this is happening. So far we have only seen two days of potential strength after months of weakness. There is no technical pattern that has yet developed indicating the market will grow. The most likely trend for US stock markets remains flat or down, with down being more probable.

We frequently cite Austrian Business Cycle Theory (ABCT) when discussing the US money supply. It is a rich and detailed explanation of how money supply growth rates impact asset prices and cause a bubble-boom and eventual crash in the economy (and thus in the stock market). The details of ABCT are complex, but this is necessary because economics is a complex topic. For a very good discussion of the cause and cure of economic depressions based on ABCT we recommend this article at the Ludwig von Mises Institute. Based on ABCT and the fact the US M2 money supply growth rate collapsed from 7.5% to 0% about 3 months ago, we think a market decline has become very likely and is approaching soon. This opinion is shared by other economists familiar with ABCT, although our interpretation differs slightly based on our technique of measuring the M2 growth rate combined with our technical forecasting techniques.

While it is possible US banks could resume rapid lending at any moment, doing so will only happen when risk of defaults drops and the potential for profits seems more likely. The Eurozone debt crisis remains a concern and this probably has US banks worried. With long-term and short-term interest rate differences having declined, US banks are less likely to lend because of how they make profits from loans. Another consideration why US banks might be highly unlikely to lend is the shrinking value of financial assets that are not include in the US M2 money supply measure. These assets are sometimes considered to be part of the M3 money supply, although M3 is no longer published by the Federal Reserve. Some of these assets have also been referred to as the shadow banking system. They are real liabilities for banks and can be tracked via the Federal Reserve’s Flow of Funds data. Zerohedge.com provided a detailed post of these shrinking assets on 6/25/12. The current excess reserves of the US banks act as an off-set for the shrinking asset values not included in the M2 measurement. These details imply the likelihood of accelerated lending by US banks remains slim. In turn, the likelihood of a bubble-boom resumption fueled by bank lending remains slim.

Continue to maintain a risk-off position and accumulate cash. Avoid all bonds and hold your price inflation hedges for the long term. An opportunity to take a short position in US stocks might develop, although our forecasting process rarely produces such signals. Money market funds in the US have exposure to European debt, so cash outside of money market funds has less risk right now. If you haven’t already moved out or minimized your money market holdings, now would be a good time to do so as the Eurozone debt crisis is much closer to being out of control.

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